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Rating Report BB 1 September 2017 Public Finance Republic of Croatia STABLE RepublicRating of CroatiaReport OUTLOOK Rating Report BB Credit strengths Credit weaknesses Ratings and outlook EU membership since July 2013 High public and private debt levels Foreign currency Long-term issuer rating BB/Stable Cyclical recovery, exiting recession High foreign-currency exposure Senior unsecured debt BB/Stable Reduced fiscal deficits and exit from Low potential-growth outlook Short-term issuer rating S-3/Stable EU’s Excessive Deficit Procedure Institutional weaknesses Local currency Rating rationale and Outlook: Croatia’s BB rating reflects the country’s EU Long-term issuer rating BB/Stable membership, recovery from a six-year recession and fiscal consolidation efforts leading Senior unsecured debt BB/Stable to an exit from the European Union (EU)’s Excessive Deficit Procedure. At the same Short-term issuer rating S-3/Stable time, the rating remains constrained by i) the country’s low growth potential, ii) high public-finance risk, given an elevated debt level combined with a high foreign-currency exposure, iii) the private sector’s high external and foreign-currency-denominated debt, and iv) institutional shortcomings resulting in a burdensome business environment. The Stable Outlook reflects Scope’s assessment that risks remain broadly balanced. Lead analyst Figure 1: Sovereign rating categories summary Rudolf Alvise Lennkh +49 69 6677389-85 [email protected] Team leader Dr Giacomo Barisone +49 69 6677389-22 [email protected] Scope Ratings AG Neue Mainzer Straße 66-68 60311 Frankfurt am Main Phone + 49 69 6677389 0 Positive rating-change drivers Negative rating-change drivers Headquarters Higher economic growth potential Reversal of public and external debt Lennéstraße 5 deleveraging Public and external debt reduction 10785 Berlin Postponement of reform programme Improvements in the business Phone +49 30 27891 0 climate Exchange rate volatility Fax +49 30 27891 100 [email protected] www.scoperatings.com Bloomberg: SCOP 1 September 2017 1/16 Republic of Croatia Rating Report Domestic economic risk Slow emergence from six-year After six years of recession, with GDP contracting by more than 12% between 2008 and recession 2014, real GDP growth turned positive in 2015 and is now expected to range between 2.0% and 2.5% over the coming years. The cyclical recovery, which Scope expects to continue in the coming years, is driven by stronger consumption due to an improving labour market, higher investment given an expected higher absorption of EU structural funds and a reversal in the credit cycle, and net exports driven mainly by tourism, manufacturing, trade and transportation. In line with its CEE peers, Croatia is a large beneficiary of EU structural funds with an allocation of about EUR 9bn for the 2014-2020 period. This is equivalent to around 3% of GDP annually, making Croatia the second-largest beneficiary of EU funds after Hungary in terms of GDP. However, the full benefits of this fund allocation are unlikely to materialise since, as noted by the European Commission (EC)1, effective absorption of EU funds is impeded by limited administrative capacities and an insufficient number of implementable projects. Figure 2: Contributions to real GDP growth (% YoY) Figure 3: EU structural funds allocations 2014-20 (% GDP) Private Exp. Public Exp. Net Exports 20 Investment Real GDP Growth 18 8 16 6 4 14 2 12 0 10 -2 -4 8 -6 6 -8 4 -10 2 -12 -14 0 IT FI IE 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 SI LT PL LV EL PT AT NL LU CZ FR SK EE ES BE SE CY DE UK DK HU HR BG MT RO Table of contents Source: Croatia Bureau of Statistics Source: European Commission Domestic Economic Risk .................. 2 The economic recovery is also being facilitated by the Croatian National Bank’s (CNB) Public Finance Risk ......................... 4 accommodative monetary policy stance. During the six-year recession, which included three years of deflation, the CNB has continued to reduce its key policy rates and External Economic Risk ................... 7 ensured ample liquidity in the banking system. Its expansionary monetary policy, which Financial stability risk ....................... 8 included reducing rates, broadening the list of securities eligible for CNB facilities, Institutional and political risk ........... 10 adjusting required reserves, and a quarterly four-year structural reverse-repo facility 2 I. Appendix: CVS and QS Results . 12 introduced in February 2016 , led to falling loan rates as well as a pickup in loan growth after several years of deleveraging. II. Appendix: CVS and QS Results . 13 Despite its emergence from a six-year recession, Croatia remains significantly more III. Appendix: Peer Comparison ...... 14 economically vulnerable than its peers. Real GDP growth is still well below the pre-crisis IV. Appendix: Statistical Tables ...... 15 level and GDP per capita on a purchasing power standard basis remains significantly V. Regulatory disclosures ............. 16 below that of peers, at around 60% of the EU-28 average. In addition, the country’s growth potential is estimated at only around 1%, a particularly weak outlook compared to other transition economies. 1 European Commission, Country Report Croatia 2017, SWD (2017) 76 final, February 2017. 2 IMF, 2016 Article IV Consultation for the Republic of Croatia, June 2016. 1 September 2017 2/16 Republic of Croatia Rating Report Figure 4: Real GDP growth (2008=100) Figure 5: GDP per capita (PPS, % of EU-28 average) Source: European Commission Source: European Commission Croatia’s low growth potential is mainly the result of adverse developments in the labour Low growth potential given force and subdued total factor productivity growth. While the unemployment rate has adverse developments in labour force and productivity fallen from its 17% peak in 2013 to around 13% in 2016, and employment has increased by about 75,000 over the same period, although mostly due to an increase in temporary contracts, the continuously shrinking labour force accounted for more than half of the reduction in unemployment. In fact, at around 60%, Croatia’s employment rate is one of the lowest in the EU, driven by low activity rates after the age of 50 due to early retirement trends. The country’s low growth potential is further exacerbated by low productivity growth, with productivity levels remaining significantly below that of peers when measured by output per employee. This may be driven by factors such as subdued investment and capital formation, which remain substantially below their pre-crisis levels. In fact, investment dropped cumulatively by around 45% between 2008 and 2015. Also constraining Croatia’s growth potential is the relatively large share of state-owned enterprises, which have a lower level of productivity than the private sector according to the European Commission3. Finally, Croatia’s cumbersome business environment is underscored by its low competitiveness rankings versus peers. According to the World Bank’s 2017 Doing Business report, Croatia ranked 43rd among 190 countries (24th in the EU-28), and it scored particularly poorly on dealing with construction permits (128th) and starting a business (95th). Similarly, the World Economic Forum’s competitiveness indicator ranks Croatia 74th among 138 countries (26th in the EU-28, ahead of only Cyprus and Greece), highlighting inefficient government bureaucracy, tax rates and policy instability as the most problematic factors for doing business. 3 European Commission, Country Report Croatia 2017, SWD (2017) 76 final, February 2017. 1 September 2017 3/16 Republic of Croatia Rating Report Figure 6: Employment rates (%) Figure 7: Potential GDP growth (3Y avg., 2016-2018F, %) Source: European Commission Source: European Commission Public finance risk Ongoing fiscal consolidation In Scope’s assessment, Croatia’s public finance risk is elevated, despite having exited with deficits below 3% the EU’s Excessive Deficit Procedure in June 2017. The six-year recession led to high Maastricht criteria deficits in the 2009-2013 period, given low revenue collections and large increases in automatic expenditures. While the deficit fell sharply to 0.8% of GDP in 2016, after hitting a record high of 7.8% in 2011, this consolidation effort was driven largely by lower public investment as well as a reduction in social benefits and lower interest expenses. Going forward, the government’s Convergence Programme for 2017-20204 foresees a budget deficit of 1.3% of GDP in 2017 and 0.8% of GDP in 2018, broadly in line with the EC’s Spring Forecast, but significantly more favourable than the IMF’s expectation of around 2%. The IMF’s caution is rooted in the high level of implementation risk associated with the numerous suggested legislative changes to achieve fiscal consolidation. The recently adopted tax reform is expected to boost investment and consumption at the expense of public finances. While the reform simplified and reduced the personal income tax (PIT) rate, the EC notes that as a consequence, the number of persons who will no longer pay any PIT will increase by 560,000, reaching 1.5 million (more than 50% of all persons with income), while higher-income earners will face a significantly lower tax liability. In addition, the corporate income tax rate was also cut from 20% to 18% and a new 12% rate for SMEs was introduced, reducing expected revenues5. Despite these measures, Scope expects a sustained moderate growth rate to keep public deficits below the 3% Maastricht threshold over the coming years. High level of debt remains a As a result of accumulating high deficits and the six-year recession, Croatia’s public debt rating constraint more than doubled from 40% of GDP in 2004 to 87%6 in 2015. Granted, debt-to-GDP fell for the first time in 2016, driven by primary surpluses achieved since 2015, and there has been positive growth plus a slight 1% appreciation in the kuna (which in itself supported debt reduction by 0.7 percentage points, according to the EC).
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